The Equity Risk Premium

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The market’s risk premium is the extra return, above the returns which can be made by investing in risk-free assets, that the equity market is expected to deliver. It can be seen as the compensation needed to attract investors away from a safe investment, such as a government bond, towards a riskier asset. In general, as market risk increases, so must expected returns.

Individual stocks and underlying factors also offer a risk premium. Factors are now being used by some fund managers in the allocation of capital, rather than the traditional method of spreading capital across the different asset classes.

On a historical basis, the market risk premium is easy to calculate. For example, if government bonds are yielding 2% while equity markets are generating 5% returns (both on an inflation-adjusted basis), then the value of the equity risk premium is 3%.

At a broad level, a risk premium is made up of a number of different yet intertwining risks, including specific business risk and liquidity risk, among a number of others.

A forward-looking equity risk premium requires an accurate expected rate of return. One model which can be used to calculate the expected rate of return is based on forecasting earnings growth using a stock, portfolio or equity market’s earnings yield.

Some studies show that the average equity risk premium tends to be slightly more than 4% in the long term – in other words, equities historically outperform government bonds by that amount. However, this figure varies quite significantly based on the model of calculation.

The equity risk premium model can be a relatively accurate gauge of investor sentiment. For instance, an equity market’s risk premium tends to shrink when the market is perceived as having momentum and being stable, since equities are seen as less risky than before. Since it is compared to risk-free alternatives, the risk premium rate is also dependent on bond yields.

An equity market will carry a higher risk premium in a bear market or when bond yields fall – as has been the case in the wake of the 2007-2008 global financial crisis. European and American central banks in particular have kept bond yields low amid “quantitative easing” programmes which have involved large-scale bond purchases.

These, and the flight of capital to safe assets in the aftermath of the global financial recession, have pushed the equity risk premium to historically high levels – meaning some analysts are questioning how valuable this model is as a predictor of equity returns. Others, though, believe that the equity risk premium remains a valid return predictor over the long term.

Meanwhile, traditional portfolio managers are paid fees to outperform the market, though many studies show that even the best active managers fail to consistently beat the market. This means portfolio managers are under greater scrutiny regarding the returns they can generate relative to the fees they charge.

Building a portfolio using both the risk-free rate of return and the equity risk premium

Diversified fund managers do not allocate all of their capital to equities, but rather hone in on their preferred level of risk by blending equities with typically less risky and less volatile bonds in a portfolio. While this tempers overall expectations about returns, it reduces total risk. Traditionally, the model portfolio split has been 60% equity and 40% bonds, though this approach is changing.

Investors can construct portfolios by measuring expected returns against risk (volatility), using performance ratios including alpha and beta.

Different sources of risk tend to be uncorrelated to each other, meaning that in addition to being a driver of returns, targeting different risks can be used as a risk-control mechanism.

Risk premia and alpha strategies

Since a risk premium is made up of a number of different risks, the investment strategy known as ‘risk premia’ refers to an investment approach which targets a specific risk in order to generate higher returns than broad equity markets.

Considered a cheaper and more transparent substitute for hedge funds, a growing number of asset managers are harvesting the benefits of risk premia strategies and including them in their portfolios.